DIN – ACCOUNTING SHENANIGANS

In 3Q08 DIN reduced guidance for the low end of the operating cash flow range by $10 million. At the same time the company reported a 13% increase in the operating profit at the Applebee’s chain. How can this be?

For the past three quarters DIN has seen an incremental benefit from direct and occupancy costs. In 3Q08 this accounted for 170 basis points of the 220 basis point improvement in margins. In the press release, management attributes the change to “purchase price accounting.” That is nothing more than saying that they changed the depreciation schedules on the Applebee’s business after they bought the chain.

Importantly, it’s a non cash event so it does not help to improve the cash flow of the company. Any way you look at it, this is a clear example of the company struggling to make the operations look better than reality.

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10/29/08 04:03 AM EDT

The Forgotten Man

“Insanity in the individual is something rare… but in groups, parties, nations, and epochs, it is the rule.”-Nietzche

The math isn’t trivial this time. You had 3 different opportunities in the last 3 trading sessions to buy stocks in our buy zone. At a bare minimum, we hope you covered. The madness of the media and the crowds alike was untenable. Volatility index (VIX) was trading over 80, and stocks were selling off on LOW VOLUME. This was not a tough shot to take.

If you aren’t into these simple quantitative market factors, surely you could have found a few stocks that were “cheap”. No matter what your investment “style”, once again, we are all looking back now on what was nothing short of a fantastic sentiment-driven buying opportunity.

On the sentiment front, we posted a note to our RE Macro clients intraday yesterday titled, “They are right freaked…” (www.researchedgellc.com, 10/28/08). This morning you can add two more sentiment surveys to the simple thesis that freaking out alongside your boss isn’t going to differentiate your career. The Institutional Investor Bullish to Bearish survey came out this morning with a -30 delta. That locks in last week’s survey as the low print in weekly investor bearishness. This comes on the back of the worst consumer confidence report EVER (yesterday), and a weekly ABC/Washington Post consumer confidence report this morning that again bounces off last week’s Barron’s Bear taking a chainsaw to a Bull’s head front page lows…

If you want to be part of investing “clubs” or run around scared of your own shadow, find a scary costume and meet the “hedgies” at their latest and greatest conference of “one on ones” in Midtown Manhattan. Halloween is right around the corner and you can get right freaked out, paint your faces, and scream and yell – just wear your Merrill Lynch badge and no one will find your behavior out of the ordinary. If you are part of a “hedgie” group, party, nation, or epoch, you are now being ‘You Tubed’ by America.

Today is the anniversary of “Black Tuesday” (1929). When we wrote our “Beware of the stock market crashing” note on 9/19/08, we did point out that Octobers are generally bad during bear markets. I can assure you that as simple as that calendar catalyst call looks today, it mystified the “hedgies”. Eerily however, some of the same “smart money dudes” were equally up in arms with me when I printed my “Buy’em” Early Look note 48 hours ago. I don’t know who pays these black cats 2 and 20 for buying high and selling low, but man would it be entertaining for their investors to read some of the self professed genius from the archives of their emotionally charged, no spell-check, crackberries.

Now that I have painted a few victory laps into this note, allow me to make one more emphatic “call” – this is NOT a Great Depression! Allow me to point you to the latest book I have been grinding through by Amity Shleas titled “The Forgotten Man.” This, folks, may very well be a Depression in the halls of compromised “Investment Banking Inc.” but it is far from it for we capitalists who are flush with cash looking to feed our families without using leverage.

In 1883, Yale’s William Graham Sumner defined the “Forgotten Man” - “he works, he votes, generally he prays – but he always pays…” Those who don’t respect history are definitely feeling shame about that now, and they should. Patterns repeat. Times are changing and it’s time to rebuild this American capitalistic system from the bottom up, not the top down. This country is oversupplied with men and women who are transparent and accountable. It is time to empower them with our trust.

The politicized “Heli-Ben” may very well give us commoners a shot today at borrowing money for free. Someone asked me in the morning meeting the other day if I would borrow money from the Fed if I could – I did a quick calculation and said, “why yes… I would borrow $1 Trillion dollars from the Fed at zero interest rates!” That’s actually what the latest bank holding companies of America (Morgan Stanley and Goldman Sachs) should do. Then, rather than believe they are God, they very well may become the financial equivalents of one. Doesn’t that possibility make your feel confident in our system? It’s cool isn’t it? Haven’t they earned our trust? Shades of Japanese and all…

The Nikkei closed up another +7.7% overnight in Japan, so we’ll be re-shorting it. After covering all but 4 of our short positions ahead of yesterday’s +10.8% short squeeze in the S&P500, we have a long list of short sales to re-populate on our books. Timing is everything, and we respect that and math above all else. There is a chance that Japan’s new government to cuts rates for the 1st time in 7 years this Friday. Yes, there is a shot that we “Forgotten Men” can actually borrow one tree-lion ($1T) dollar-zzz for free – the only caveat is that we may have to do it in Yen. Maybe that’s why everyone wants that Asian currency all of a sudden…

Yesterday’s resistance level in the S&P500 now becomes a support level. I think the S&P can continue to get squeezed all the way up to 1026, and nothing will have changed this market’s intermediate negative “Trend”. That said, 11-17% melt-up moves in the US market are “Trades” you better be on the right side of, or in the land of black cats and “hedgies”, you too may become a “Forgotten Man”…

Best of luck out there today,KM

Long ETFs

VYM – Vanguard High Dividend Yield ETF – This is a fund of the U.S. largest, blue chip companies and currently pays a dividend yield of ~3.8%.

FXC – Currency Shares Canadian Dollar Trust – Blackstone CEO Steve Schwarzman called Canada an “Oasis of Stability” in the banking crisis at conference in Quebec. While we agree with the view, the source makes us wary.

EWG – iShares Germany – The German government announced that it will finance part of its 500BN Euro rescue package by issuing bonds to banks in exchange for preferred stock. Volkswagen is down ~40% as the short squeeze has ended.

FXI – iShares China – The Chinese government cut the benchmark 1-year lending rate by 27 bps this morning for the3rd time in three months,

EWH - iShares Hong Kong - Radio Television Hong Kong quoted Premier Wen Jiabao as saying that China will "help" Hong Kong through crisis while speaking in Russia. Measures mentioned include increasing communication between Hong Kong and the mainland, speeding up infrastructure projects, ensuring food supplies and expanding tourism to the city according to the report.

Short ETFs

IFN – India Fund – The Rupee advanced for its second straight day and Indian 10-year yields declined on speculation of future rate cuts.

UUP – U.S. Dollar Index – The focus in the U.S. today is the FED, where a 50 bps cut is all but priced in. The US$ has lost 1.7% of its value in the last 48 hours.

EWU – iShares United Kingdom – In follow through from the U.S. yesterday, the FTSE is up~5.0% on the back of the pound rallying versus both the Euro and the dollar. The Chancellor of the Exchequer also pledged more borrowing, to now exceed the 40% limit, to support the U.K. economy.

Keith R. McCulloughCEO & Chief Investment Officer

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10/28/08 05:03 PM EDT

EWH: Ghosts of Tiananmen; Don't Be Scared!

We have been bullish on both China and Hong Kong via the FXI and EWH etfs, respectively. While we have been early on both, we are also scaling into positions after a more than ~60%+ decline in both markets from their “It’s Global This Time” highs.

Less than 48 hours ago the Hang Seng closed down -12.7% for the day, which was its worst one day decline the Tiananmen Square crackdown in May 1989. The talking heads on T.V. were very vocal in emphasizing this point and comparing the sell off between those periods, even though they have no fundamental association.

Since the pundits were comparing this decline in the Hang Seng market to the decline during Tiananmen Square, we thought we would look back at the charts. No surprise, the Tiananmen Square sell of 1989 marked a panic bottom . . . and over the next 12-months the Hang Seng was up +50%.

We wonder what the “Global Recession” sell off in Hong Kong was marking earlier this week, probably not the top. Bottoms are processes, not points – oh, and by the way, the EWH was up a nifty +17% today… how ironic.

Daryl G. JonesManaging Director

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Volkswagen: Driving out the shorts...

Just as were finishing our morning coffee at 5:46 a.m. this morning Keith fired the Macro Team a question, “What is going in Germany?”. After a few minutes of digging, the answer was fairly obvious, Volkswagen was up 93% and Volkswagen is the largest component of the DAX. These gains came on the back of Porsche’s Oct.26th announcement that is plans to increase its stake in Volkswagen to 75%.

Going into this “event”, as the butterfly wing nut “event driven” hedgies like to call such things, Volkswagen was the most heavily shorted mega cap stock on the DAX. As of October 23rd almost 12.9% of Volkswagen common stock was shorted. Porsche owned 42.6% prior to its announcement and 75% as of its announcement Sunday night, the implied short interest was more than 50% of free float as of Monday morning.

Ironically, the shorts initially focused on Volkswagen because of its relative strength. Unlike the Japanese and Korean auto manufacturers that are grappling with heavy dependence on a single slowing market (and unlike the toxic sludge that is all that’s left of the major Detroit companies), Volkswagen had a comparatively robust balance sheet and franchise. In the minds of the “event driven” club, this meant that the stock price had further to fall, so… they ingeniously all piled in together hoping to ride it down on the “macro” story.

The average European market “event driven” hedge fund that is still bothering to report to the service we subscribe to was down -16% for the year last week. This one short squeeze “event” should “drive” that number a few points lower.

Keith and I learned a lesson early in our careers, beware the short squeeze. Indeed.

Daryl G. JonesManaging Director

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10/28/08 02:28 PM EDT

"They" are right freaked ahead of Halloween, shocking...

Surely, you’ve seen today’s US consumer confidence levels – they hit a record low, and the information starved media pounced on it. Was this a surprise? Apparently to some, unfortunately, it was!

Touching the 845 level, the S&P500 bottomed intraday shortly after this revisionist historian data was released. If you sold that low, you probably fee shame here – I would. Manage risk proactively rather than reactively - that’s been as clear a lesson in 2008 as any.

Interestingly, 5000 consumers answered the confidence survey this month. The responses that they provided were more negative than the answers that their parents gave in 1980 when CPI inflation levels were approaching a 13% increase year-over-year and the revolutionary Iranian government was holding 52 American citizens hostage. The responses they provided this month were also more negative that the responses that their grandparents gave in 1975 when US unemployment levels reached 9% and Saigon fell to the North Vietnamese army.

Historical context is always critical. People are right freaked out here. I used to be, but with the S&P500 45% higher. Buy low, sell high.

Keith McCullough & Andrew Barber.Research Edge LLC

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10/28/08 12:34 PM EDT

BWLD – Going Against the Grain

BWLD reported 3Q08 same-store sales up 6.8%, with menu pricing up about 3.5%, which implies 3%-plus traffic trends. Cost of sales declined 90 bps, primarily as a result of its increased menu pricing and a decrease in the cost of fresh chicken wings (averaged $1.17 per pound versus last year’s average cost of $1.24 per pound). Management reiterated its FY08 guidance of 15% unit growth, raised its revenue growth to more than 25% (from 20%) and widened its EPS range to up 20%-25% (from 25%). On top of that, the company is now expecting more of the same in FY09 with 15% unit growth, revenue up 25% and EPS up 20%-25%, and management said it is being conservative as a result of the current environment. The FY09 revenue and EPS guidance relies on BWLD’s ability to achieve its 15% unit growth so the company has shifted its strategy to increase the ratio of company-owned units.

Any one of these prior statements is completely unheard of in the current casual dining environment. Most operators are reporting significantly negative traffic trends and increased pressure on the commodity front. No other casual dining company is forecasting 25% EPS growth in FY09 on top of 25% growth in FY08. And, most other casual dining operators are slowing development targets for FY09 and/or shifting more of their growth to franchisees.

Taken at face value, all of this should translate into outperformance for BWLD, but I have my concerns outside of the fact that the company opened up the lower end of its prior EPS guidance. For reference, it appears that this lower EPS range and 3Q earnings miss is due largely to higher impairment costs as a result of BWLD’s Don Pablo’s relocations and facility remodels/upgrades (which should begin to normalize in 4Q).

In today’s environment, BWLD’s 6.8% comparable sales and 3%-plus traffic growth are nothing short of amazing, but I was surprised that even with such strong top-line results that the company was not able to achieve leverage on the labor line. Management attributed this deleveraging to higher management wages and higher training costs from increased openings and stated that it expects to get leverage on the labor line on a YOY basis in FY09. I am not convinced BWLD will be able to achieve this YOY improvement because they are only expecting modest same-store sales growth in FY09 (versus the 6.8% in 3Q) and the acceleration of company-owned openings will continue into 2009.

I also think BWLD’s FY09 guidance is aggressive as its 15% unit growth although more weighted toward company-owned growth still assumes 50 franchise openings, which may be difficult given the current credit environment. Management stated that it thinks it is being conservative but also said that despite the fact that BWLD’s franchisees have a very strong development pipeline, “they have commented that they have seen perhaps a slowing in some of their financing.” BWLD is accelerating its company-owned growth at a time when most of its casual dining competitors are slowing growth. Although BWLD’s recent results are not comparable to other casual dining operators, I never like to see a company significantly increase its capital expenditures as a percent of sales (particularly in today’s difficult environment) because it has the potential to put increased pressure on returns.

4Q08 trends:BWLD said its same store sales-to-date in the fourth quarter are up about 3%. This represents a significant slowdown from 3Q08’s 6.8% number and BWLD is facing an easier comparison from 4Q07 of up 3.4% relative to 3Q07’s 8.3% number. Additionally, menu pricing is running up a little over 3.5%, which implies slightly negative traffic.

BWLD’s YOY commodity favorability as it relates to the cost of fresh chicken wings also appears to be going away in 4Q as October and November wing prices are averaging $1.24 per pound, flat with last year.

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